Greg Ip, Chief Economics Commentator at the WSJ, recently had some thoughtful comments on the national debt:
“There are at least two reasons [the growing debt] matters. First, when the next recession hits, the U.S. may want to open the fiscal taps but instead have to do the opposite as tax collections sink and deficits mount. Second, while markets and the Federal Reserve both doubt interest rates will go much above 3% for the foreseeable future, the U.S. is acutely vulnerable if that is wrong because the debt is so large and so much of it comes due each year, and would have to be refinanced at higher rates.”
Ip covers a lot of ground in this piece and offers a pretty balanced view. I think he’s right not to be too blase about the national debt. Governments can wreck an economy faster than many think, but I think these arguments about the USA are generally based on false understandings and exaggerations in the severity of the problems. Let’s talk about Ip’s worries in a bit more detail.
Does the USA Have Policy Flexibility in an Economic Downturn?
This has become a common concern in recent years as the Fed has expanded its balance sheet and cut rates and deficits have remained moderately high. The concern is that the USA has no policy ammunition left. This might be true on the Fed’s side, but it is less so on the Treasury’s side. After all, the deficit is just 3.5% of GDP as of now. It ballooned to over 10% of GDP during the crisis and was as high as 27% during the 1940s.
We know that a deficit of 10% of GDP didn’t cause high inflation in 2009 so it’s safe to assume we have quite a bit of policy flexibility here. If the US economy were to enter a recession the deficit would naturally expand to some degree as tax receipts decline and spending increases automatically, but there’s no reason to think that we wouldn’t have some flexibility to expand the deficit with some discretion as well.
